Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals?

Abstract: This paper examines whether the incidence of earnings management by UK firms depends on board monitoring. We focus on two aspects of board monitoring: the role of outside board members and the audit committee. Results indicate that the likelihood of managers making income‐increasing abnormal accruals to avoid reporting losses and earnings reductions is negatively related to the proportion of outsiders on the board. We also find that the chance of abnormal accruals being large enough to turn a loss into a profit or to ensure that profit does not decline is significantly lower for firms with a high proportion of outside board members. In contrast, we find little evidence that outside directors influence income‐decreasing abnormal accruals when pre‐managed earnings are high. We find no evidence that the presence of an audit committee directly affects the extent of income‐increasing manipulations to meet or exceed these thresholds. Neither do audit committees appear to have a direct effect on the degree of downward manipulation, when pre‐managed earnings exceed thresholds by a large margin. Our findings suggest that boards contribute towards the integrity of financial statements, as predicted by agency theory.